Tax treatment of individual owners of bitcoin and other virtual currencies held for personal use or investment

Editor: Mary Van Leuven, J.D., LL.M.

The number of people using digital currencies is growing rapidly, and, not surprisingly, the IRS is paying attention. Although Coinbase, a U.S.-based digital currency marketplace, states on its website that it has more than 10 million customers, the IRS reported that for tax years 2013-15, only approximately 800 individuals per year filed Form 8949, Sales and Other Dispositions of Capital Assets, to report bitcoin transactions. Last year, the IRS was successful in requiring Coinbase to disclose the account records of over 14,000 customers whose bitcoin transactions exceeded $20,000 per year (Coinbase Inc., No. 3:17-cv-01431 (N.D. Cal. 11/28/17)).

The IRS indicated that the information will be used to “identify and obtain evidence on individuals using bitcoin to either launder money or conceal income as part of tax fraud or other federal crimes” (IRS Contract with Chainalysis Inc., p. 3 (Nov. 24, 2015)). In addition, the IRS has reportedly entered into a license agreement to deploy software to identify the owners of digital wallets used to store bitcoins, in an attempt to track transactions.

Bitcoin is the most widely circulated digital currency, but there are many other varieties of “altcoin,” with ethereum a distant second (as of March 2018) and climbing. Consider bitcoin to illustrate the basic steps in the creation and use of digital currency:

1. Bitcoins are created electronically when “miners” use a complex algorithm to verify and record transactions in “blocks” on a public ledger known as a “blockchain.” Miners are compensated with the bitcoins created.

2. Users purchase bitcoins online using traditional currency via exchanges (e.g., Coinbase or Bitstamp) or private sellers.

3. To receive or spend bitcoin, users either install a bitcoin wallet on their personal devices or use a web wallet in the cloud. The wallet generates a “key pair”: the public address and a private address (a “private key”). The public address identifies the wallet and can be shared so the user can receive bitcoins. The private key is held by the owner and used to spend or transfer the bitcoins from the wallet.

4. Bitcoin transactions are recorded on a computer file that acts as a public ledger that anyone can view using a website called a blockchain browser. The blockchain contains information on every transaction ever executed in the currency, including the value at each address at any point in history.

Bitcoin transactions are decentralized, meaning no central bank or other institution holds the value of bitcoin. Also, contrary to popular belief, bitcoin transactions are traceable — the identities of the parties are not disclosed, but the details of the transaction are public. Bitcoin uses public/private key pairs rather than identity data as addresses. Once a key pair is tied to an identity, however, purchase and transaction activity can be readily collected and analyzed.

IRS guidance

Bitcoin was first made available to the public in 2009, but it was not until 2014 when the IRS released Notice 2014-21 that taxpayers had any guidelines on federal income tax treatment. The notice views virtual currency as “a digital representation of value that functions as a medium of exchange.” And, although it operates like a currency in some environments, it does not have all the attributes of real currency, in particular, legal tender status in any jurisdiction.

The IRS has focused on virtual currencies that are convertible — that is, have an equivalent value in real currency or act as a substitute for real currency. Bitcoin is cited as an example of a convertible virtual currency because it can be digitally traded and purchased for, or exchanged into, U.S. dollars or other real or virtual currencies.

The notice treats virtual currency as property for federal tax purposes and applies general tax principles applicable to property transactions. The notice does not treat virtual currency as currency that could generate a foreign currency gain or loss under Sec. 988.

Before tax reform and the passage of the 2017 tax law (P.L. 115-97, known as the Tax Cuts and Jobs Act (TCJA)), some taxpayers took the position that an exchange of virtual currency for some other form of currency could be treated as a tax-deferred, like-kind exchange under Sec. 1031. The TCJA amended Sec. 1031 so that property eligible for like-kind treatment is limited to real property, clearly closing off tax deferral for investors in virtual currencies.

Note that this item discusses in broad terms taxation of virtual currency held by individual taxpayers as an investment or for personal use. The IRS’s position in Notice 2014-21 regarding traders or those otherwise engaged in a virtual currency trade or business, such as bitcoin miners, is noted below.

Broadly, the 2014 notice addresses three uses of virtual currency:

1.Virtual currency held for investment as a capital asset: When virtual currency is exchanged for other property (including other forms of virtual currency), the taxpayer must recognize gain on the difference between the fair market value (FMV) of the property received and the taxpayer’s adjusted basis in the virtual currency sold or exchanged. If the virtual currency is held as a capital asset (as with stocks, bonds, and other investment property), any gain or loss from the sale of the asset is taxed as a capital gain or loss. Otherwise, if the virtual currency is not held as a capital asset (e.g., inventory and other property held mainly for sale to customers in a trade or business), the taxpayer realizes ordinary gain or loss on an exchange.

Although not addressed in the notice, if the virtual currency is treated as a capital asset, the net investment income tax would apply to the change in value during the time the taxpayer held it.

2.Virtual currency used to pay for goods and services: The FMV (measured in U.S. dollars) of virtual currency received by a taxpayer in exchange for goods and services must be included in gross income on the date received. Taxpayers using virtual currency to make payments for goods and services are subject to withholding requirements and information reporting to the same extent as any other payment made in property: The FMV of virtual currency paid as wages is subject to payroll withholding and must be reported on Form W-2, Wage and Tax Statement. If the FMV of virtual currency paid to an independent contractor exceeds $600, it must be reported to the IRS and the payee on a Form 1099. If the FMV of virtual currency payments paid as fixed and determinable income to a U.S. nonexempt recipient exceeds $600, it must also be reported. If applicable, the payment is subject to backup withholding when a taxpayer identification number is not obtained.

3. Virtual currency received as earnings from the activity of mining the virtual currency: One example of virtual currency mining is when a taxpayer receives bitcoin in exchange for using computer resources to validate bitcoin transactions and maintain the public ledger. If the activity constitutes a trade or business and is not undertaken by the taxpayer as an employee, the FMV of the virtual currency on the date of receipt is includible in gross income, and the net earnings from that activity are subject to self-employment tax.

Individual taxpayers are required to use Form 8949 to report virtual currency transactions and, although the notice specifies that these transactions are subject to information-reporting requirements, it may be unlikely that many users or investors will receive a Form 1099, Form W-2, or other documentation reporting their income from virtual currency transactions. Notwithstanding, the notice alerts taxpayers that penalties may apply for underpayments attributable to virtual currency transactions and failure to timely report. Penalty relief may be available to taxpayers who are able to establish that the underpayment or failure to properly file information returns is due to reasonable cause.

Issues still to be addressed

Notice 2014-21 left many tax issues unaddressed, and the IRS’s response to subsequent requests for clarification or additional guidance has been simply to refer to the original notice without further comment.

FBAR reporting: To date, no official guidance from the IRS has been issued regarding the requirement to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), reporting the value of virtual currency held with exchanges in foreign countries. Arguably, when the value of the virtual currency held offshore, together with other interests in foreign financial accounts, exceeds $10,000 in aggregate at any time during the calendar year, the holdings may be subject to FBAR reporting. The IRS website provides an email address for questions about FBAR reporting. When the IRS was contacted with the question, “Are bitcoin accounts reportable on the FBAR?,” the response received was: “[I]f you can show that there is an account relationship between you and the custodian that is holding the bitcoins for you, then it is reportable on the FBAR.”

Adjusted basis: Purchases paid for with virtual currency are treated as two transactions: (1) disposing of the virtual currency and (2) spending the dollar equivalent amount. In effect, this requires virtual currency users to calculate a gain or loss every time they make a purchase — no de minimis exception applies (as for personal transactions of less than $200 under Sec. 988(e)).

Gain or loss from exchanging virtual currency is treated in a similar manner to the sale or exchange of securities, but determining the cost basis and holding period is less straightforward. Stock trades are made in a brokerage account, while virtual currency trades occur within wallets that are held either with a third-party exchange or on the user’s electronic device. The notice refers to IRS Publication 551, Basis of Assets,for the computation of basis but does not provide any insight as to whether virtual currency should be characterized as a security, commodity, or other type of property. In September 2015, the Commodity Futures Trading Commission classified bitcoin as a commodity, but other virtual currencies could be classified as securities or other types of property.

When a taxpayer acquires securities on different dates or at different prices, the Sec. 1012 cost-basis regulations provide methods for identifying the stocks and bonds sold. If a taxpayer does not adequately identify the lot sold, the first-in, first-out (FIFO) method applies in determining the cost basis. Since exchanges and wallets are not set up to easily choose which currency units to sell or exchange, FIFO would appear to be the logical default position. If a purchaser manages his or her own wallet and can specify the units to be spent, then actual delivery may apply. If a taxpayer’s bitcoin transactions are managed by a third-party exchange, FIFO will most likely be the default method unless the third-party exchange can provide information on its accounting method for reporting virtual currency transactions.

Accounting for spinoff currencies such as bitcoin cash: In August 2017, holders of bitcoin became entitled to five units of bitcoin cash for every five units of bitcoin held. Bitcoin cash is a new currency created using a different version of the bitcoin software, and there is some confusion as to its nature and whether its issuance is similar in character to a corporate dividend or share split. A split involving bitcoin gold followed in October 2017, and occurrences of splits or “airdrops” in other forms of cryptocurrency are becoming more common. In response to requests for guidance, the IRS reiterated that the rules are set out in Notice 2014-21. Following the principles of that bulletin, the receipt of virtual currency is likely treated as the receipt of property and taxable income to the extent of its FMV.

For many bitcoin investors, this is complicated by the fact that Coinbase, the exchange that manages the accounts of many bitcoin holders, did not distribute the bitcoin cash to its customer accounts until December 2017, raising the question of whether the FMV is calculated at the date bitcoin cash was created in August 2017 or the date it was distributed. In addition, some virtual currency owners chose not to take any action to claim the split coins due to security or other concerns and, as a result, never took ownership of the property. Given price volatility, whether and when the receipt of this property is taken into income is a critical issue in determining the tax implications.

State taxes: So far during 2018, 19 states and the District of Columbia have introduced virtual currency or blockchain legislation covering issues such as tax policy, creating task forces, and applying sales and use tax (National Conference of State Legislatures, 2014-2018 Gold Standard and Alternative Currency Legislation (Feb. 22, 2018)). Most states have not issued guidance on income tax treatment. In the absence of state guidance, taxpayers will need to consider how the state taxes other forms of currency and to what extent state tax treatment follows federal rules.

Actions for tax preparers

The IRS issued high-level guidance, but many questions regarding income tax treatment that users and investors in virtual currency may face have been left unaddressed. Because the IRS is now aggressively pursuing virtual currency account holders, tax preparers will need to be proactive in helping their clients identify and report any potentially taxable transactions. Given the substantial penalties for failure to file an FBAR and in the absence of definitive guidance on FBAR reporting for offshore virtual currency accounts, it may be prudent for taxpayers to report these investments when the aggregate of foreign virtual currency and other financial accounts exceeds the threshold.

These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. 

EditorNotes

Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.